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Box 3.1ESCOs and Energy Performance ContractingPity the poor small factory owner. Busy running her business, she thinks there may be opportunities to save onenergy expenses, but does not think it a good gamble to invest time and money in an energy audit. What if thereare no savings? Or suppose the auditor recommends replacing old motors or boilers. Where will the proprietor,already at her borrowing limit, find funds? And how can she be sure that the investment will pay off?Enter the ESCO. Part consultant and part banker, the ESCO offers to reduce the factory’s energy costs by a specifiedamount, splitting the gains with the owner. To do this, the ESCO will finance, purchase, and install any requiredequipment, carrying the loan on its own balance sheet. The owner need merely collect the savings.This arrangement is called energy performance contracting and is the canonical form of ESCO. It requires reliableenforcement of contracts in order to work, given the complicated interdependence of lender, ESCO, and client.Other, simpler, arrangements are also possible.Source: IEG, based on Taylor and others 2008.Prescription: GuaranteesThe barrier diagnosis was partially flawed, so the guaranteeswere less transformative than hoped. The assumptionwas that banks practice project finance—in other words,they will finance a factory to set up a new assembly line,weighing the cost of the equipment against the return itprovides. But, the diagnosis continued, the banks don’tknow how to appraise energy efficiency projects, whichgenerate a cash flow from energy savings rather than fromincreased sales.In reality, most banks in these countries simply do not dopractice project finance, because there is no way to ensurethat they will get returns from that particular pieceof equipment. They are concerned with getting repaid andtherefore look beyond the project at borrowers’ overallbalance sheets and collateral. So for many banks the coreconstraint is their borrowers’ lack of creditworthiness, notthe novelty of energy efficiency. However, a better understandingof energy efficiency did help banks market loansto their more creditworthy customers. And the ChinaUtility-Based Energy Efficiency project (CHUEE) hashelped banks structure efficiency loans as project finance,putting savings into escrow accounts which substitute forfixed collateral.In China, collateral requirements are onerous. Hence, guaranteeswere important for credit access by cash-strappedESCOs and small and medium enterprises. AlthoughChinese banks welcomed the guarantees, they were notobviously critical to improved credit access by larger enterprises.In CHUEE, which catered to larger firms, 91 percentof a sample of borrowers said they could have financedtheir energy efficiency investment without the project andits guarantee, though perhaps more slowly (IEG 2010b).In IFC’s European projects, the guarantees, although attractivelypriced, were generally not appealing to banks fortheir small and medium enterprise (SME) or municipallending. These were familiar markets, and the banks werecomfortable bearing the risk of lending to these clients.Guarantees were more successful with new or unconventionaltypes of projects and borrowers, such as retrofittingapartment blocks by homeowner associations in Hungaryand renewable energy projects in the Czech Republic, whenthe regulatory framework and feed-in tariffs were still untestedand uncertain.It is noteworthy that almost none of the guarantees havebeen called. This experience may convince IFC to becomeless risk averse. In the CHUEE project, the IFC’s $207 millionguarantee was not at serious risk, buffered by a GEF-fundedfirst loss guarantee. The first loss was much smaller in thecase of Hungary’s OTP Schools Energy Efficiency project(see next page).Guarantees helped less creditworthyborrowers but did not trigger markettransformation.In sum, the guarantees were useful for less-creditworthyborrowers in underdeveloped financial markets. But theydid not have a large transformative effect on reducing commercialbanks’ risk aversion and are likely to be a permanentrather than temporary measure.Prescription: ESCOsThe Energy Conservation Project’s introduction of ESCOs(called energy management companies, or EMCs, in China)had significant direct effects. The three pilot companies realizedan average financial rate of return of 18 percent, withassets growing from $20 million in 1999 to $91 million in2006. The total ERR (including benefits to the EMC’s clients)was calculated by IEG at 50 percent without CO 2benefits,or 58 percent with CO 2at $6/ton of CO 2. Total claimedenergy and CO 2savings were 6 million tons of coal equivalentand 18.6 million tons through 2006—below appraisal36 | Climate Change and the World Bank Group